Don’t “Buy the Dip” in Treasuries, urges ECM AM’s Alastair Thomas

Alastair Thomas, head of Rates & Treasury Management at ECM Asset Management,

The Fed has confirmed its intentions, if the economic data supports it, to reduce asset purchases later in 2013 and possibly end purchases in mid-2014.

The market has suddenly woken up to the fact that it will be weaned off QE and stock and bond markets have reacted by rapidly adjusting lower. Future rate hikes in the US have started to get priced in more realistically (or at least more in line with the Fed’s own expectations). For example, the December 2015 Fed Funds futures have sold off 40bps to around the 1% yield area, which was the median of the Federal Open Market Committee’s (FOMC) March forecasts. In my opinion, once the Fed starts to raise rates, which they have made clear will only happen after QE has ceased, they are likely to raise rates around 100-150bps per annum (still slower than 1999 and considerably slower than 1994 and 2004). On that basis there is still some room for further moves higher in forward rates which might happen if there is some strong economic data although in the short term these have probably moved enough. For example, the March 2015, March 2016 eurodollar spread currently implies a 92bps move in Libor fixings between those dates (having been 53bps on 24th May).

Since 24th May 10 year US yields have moved 45bps higher to 2.45% and dragged other interest rates higher (UK 10 year by 50bps and German 10 year bunds by 27bps). The US has underperformed Germany as one would expect as it is their asset purchase programme that is being reduced whereas the European Central Bank (ECB) will continue with their current accommodative policies due to their weaker economy.

Although the rise in yields has been substantial when compared to the low levels earlier this year, yields are still abnormally low in a historic context. The graph below shows 10 year US yields over the last 30 years and you can see how 3% yields would be still abnormally low even if they may be appropriate for a slow growth environment. We will likely see some consolidation in yields at the current levels after such a fast move, possibly retracing to around 2.40% (or perhaps even the 2.25% major yield resistance) but ultimately there is still more of a risk of higher rates than considerably lower rates.

Exacerbating the sell-off is the fact that investors became addicted to the “lower for longer” mantra due to many central banks’ extremely accommodative policies. This applied in the US, UK and eurozone. With the ECB slowly cutting rates and providing liquidity to the markets via the Long-Term Refinancing Operations (LTROs), the trade of receiving 1 year swap rates a couple of years forward resulted in nice returns via “carry and roll-down”. As you move forward in time even if the yield curve is unchanged the forward rate naturally reduces as you get closer to the start of the trade. For example, 1 year 3 years forward in euro swaps reached highs of 3.82% on 11th April 2011 and a year later the yield on that particular trade was 1.33% thus making almost 250bps. These types of trades are now being exited despite the market not expecting the ECB to raise rates until later in 2014 or early 2015 and that volume of selling is driving markets to higher yield levels than might otherwise be expected. The very front end of the market correctly predicts little movement in ECB rates.

The interesting question is whether higher yields will impact economic growth. If the growth is only being driven by low yields induced by QE there is clearly a risk that as yields normalise the higher borrowing rates could have a negative impact on the economy. Our base scenario has been that gradually rising market rates will unlikely impact the current growth forecasts and although the initial move has been rapid it is not so large that it is likely to change those assumptions. If economic growth estimates are not materially impacted, the Fed will most likely reduce QE in September to $65-70bn per month from the current $85bn. The Fed has hinted at a sort of insurance against the market pricing in too rapid and early rate hikes by suggesting they may revise the 6.5% unemployment rate threshold for rate hikes and Fed members have already started to make comments to try and dampen rate volatility. Central bank rhetoric has stepped up this week in Europe as well with ECB and BoE members stating that they are a long way from raising rates.

A couple of years ago the YouTube cartoon called “Buy the Dip” explained how to make easy money from QE: “it is so easy to make money…its free money…you have the US government promising everyone that they will buy everything for ever…buy the dip and you will make money too.” I suspect that this mentality is disappearing and in time will be replaced by the “sell the rally” mentality with regards to treasuries.

 

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